Opinion – Martin Wolf: Tough economic times ahead

Central banks are determined to get inflation back under control. That was the message from Jay Powell, chairman of the Federal Reserve, and Isabel Schnabel, an influential member of the board of the European Central Bank, at the Jackson Hole symposium last week. So why did central banks push this message so hard? They are right? Mainly, what might this imply for future policies and the economy?

“Reducing inflation will likely require a sustained period of below-trend growth. Higher interest rates, slower growth and softer labor market conditions will bring inflation down, but will also pose some problems for households and businesses. Those are the unwanted costs of reducing inflation. But a failure to restore price stability would mean far greater pain.” Those were Powell’s words.

Schnabel again argued that central banks must act decisively, as expectations are in danger of being unanchored, inflation has been persistently too high, and the costs of controlling it will increase the longer action is delayed. There are risks in doing too much and doing too little. However, “determination” to act is a better choice than “caution”.

It is not difficult to understand why central bankers say what they are saying. They have a clear mission to control inflation that they have not been able to fulfill. Not only headline inflation, but also core inflation (excluding energy and food) has been above target for a long time. Of course, this unintended outcome has a lot to do with a series of unexpected supply shocks, in the context of the post-pandemic trend towards consumer goods, restrictions on energy supplies and now the Ukraine War. But scissors have two blades: demand and supply. Central banks, most notably the Fed, persisted with the ultra-lax policies of the pandemic for a long time, although US fiscal policy was also very expansionary.

In an important analysis, Ricardo Reis, from the London School of Economics, points out four reasons why this happened. First, central banks have repeatedly interpreted supply shocks as temporary interruptions rather than quasi-permanent impacts on potential output. Second, they misinterpreted short-term expectations by focusing too much on the mean rather than shifting towards higher expectations at the upper edges of the distribution. Third, they tended to see credibility as an infinitely deep well, rather than a shallow well that needs to be replenished promptly. Thus, they failed to notice that the distributions of long-term inflation expectations were also turning against them. Finally, their belief in a low neutral interest rate led them to worry too much about deflation and too little about the return of inflation. A central point is that these were intellectual errors. So, in my opinion, was the inattention to monetary data.

In essence, central banks are playing tag because they fear they risk losing credibility, and if they did, the costs of getting it back would be much greater than taking action now. This fear is reinforced by the risks to wage inflation from the combination of high price inflation and strong labor markets. The fact that higher energy prices drive up the prices of just about everything makes that risk greater. This could then start a second round of the price-wage spiral.

They are right to adopt this view. A shift to a 1970s-style era of high and unstable inflation would be a calamity. However, there really is a risk that the downturn in economies caused by a mix of falling real incomes and tighter financial conditions will cause an unnecessarily deep downturn. Part of the problem is that calibrating monetary tightening is particularly difficult today, because it involves raising short-term rates and shrinking balance sheets at the same time. An even bigger one is that policymakers haven’t faced anything like this in four decades.

In the US, there is a particularly optimistic view of “immaculate disinflation” enacted by the Federal Reserve. This debate focuses on whether it is possible to reduce labor market pressure by reducing vacancies without increasing unemployment. An important article by Olivier Blanchard, Alex Domash and Lawrence Summers argues that this would be unprecedented. The Fed responded by saying that everything is now unprecedented, so why wouldn’t that be? In response, the authors of the original paper insist that there is no good reason to believe that things are unprecedented. Think about it: how can a general monetary tightening be expected to hit only companies with vacancies? It will certainly hit companies that would also have to lay off workers.

If the planned tightening of monetary policy tends to trigger a recession in the US, what could happen in Europe? The answer is that recessions are likely to be deep, as the energy price shock is so great. Here, too, the balance between the impact on supply and demand is not clear. If the impact of higher energy prices on supply is greater than on demand, demand will also need to be contained.

Monetary policy will play a role in European history. But at the heart of its current crisis is the energy shock. Central banks cannot directly do anything about these real economic disturbances. They must fulfill their mission of stabilizing prices. But a big effort must be made to protect the most vulnerable from the crisis. Furthermore, the most vulnerable will include not just people, but countries. A high level of fiscal cooperation in the eurozone will be needed. A political understanding of the need for solidarity within and between countries is a precondition.

A storm came from eastern Europe. It needs to be supported. How best to do this will be the subject of future columns.

Translated by Luiz Roberto M. Gonçalves